Meet your new robot asset manager


























Yesterday afternoon, the Wall Street Journal, New York Times, and other outlets reported that Black Rock, the world's largest investment fund management company with $5.1 trillion in assets under management, is radically revising its equity management offerings by announcing what the Times calls "an ambitious plan to consolidate a large number of actively managed mutual funds with peers that rely more on algorithms and models to pick stocks."

The move is being heralded as a sign of things to come in the world of asset management. Only a small percentage of assets managed at Black Rock were actively managed before the move -- about $201 billion at present, according to the Times story -- due to the firm's focus on so-called passive strategies, including ETFs (Black Rock owns iShares, acquired from Barclay's) and index funds. Now, the firm is reducing its emphasis on active management still further, firing several active portfolio managers and supporting staff, and instead emphasizing a lineup of "quant" funds, which rely more on computer models and algorithms. The news headlines are calling this move "Machines Rising over Managers to Pick Stocks" and "Relying more on robots rather than humans."

Reading further into the company's reasoning reveals that the firm's equity asset managers had underperformed index funds in recent years, that the shift to algorithms rather than managers allows lower management fees, and that leadership believes new technologies such as "big data or even artificial intelligence" are making human-based investing less relevant. The executive in charge of the change says, "The old way of people sitting in a room picking stocks, thinking they are smarter than the next guy -- that does not work anymore." 

The Journal article does note, however, that Black Rock will retain some actively managed offerings, including "country- and sector-focused stock products in which executives believe they can outperform, funds that pursue specific outcomes such as social impacts, and riskier funds that make more concentrated bets" but that "The changes weed out actively managed stock funds that closely follow indexes."

As active managers ourselves, we approve of these changes at Black Rock, and do not see them as the "end of active management" due to the "superiority of the robots" (or the quants) at all. In fact, we believe that the largest mutual fund company in the world has just publicly acknowledged the drawbacks of huge funds that are forced by their size to "closely follow indexes" and has made a rational decision to focus on other strategies -- including those that make "more concentrated" investments (which is a strategy that we ourselves favor, and one we have used to outperform indexes over long periods of time). 

In fact, we noted almost two years ago that the Black Rock CEO had inadvertently admitted what we believe to be one of the central problems of index and ETF investing -- the fact that they are forced to own everything, good and bad -- during an interview alongside Carl Icahn that turned into a fairly exciting debate. The same criticism can be applied to "actively managed stock funds that closely follow indexes." 

That said, we personally do not favor quant strategies, for reasons we have detailed in previous posts (including one from 2010 discussing a story touting "AI that picks stocks better than the pros"). We believe that the single most important factor of successful investing involves having a consistent investment philosophy which informs your selection of companies whose stock you will own. This is the opposite of what algorithm-based strategies usually do -- because those algorithms are frequently changed to try to capture "what's working now." And, on a larger scale, Black Rock's shift towards more emphasis on quant strategies (in addition to their existing emphasis on ETFs and indexes) can also be seen as a shift towards "what's working now." 

Of course, if their strategy is flawed, then they should change their strategy. However, we advise investors to be very careful when selecting these new strategies, if those strategies themselves are not grounded in a consistent investment discipline. Otherwise, in a few years, they might find themselves being told that now it's time to shift into the new "next best thing."


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Investment Climate Jan 2017 - Favorable Winds of Change



The markets reacted to the surprising results of the U.S. Presidential election with a resounding vote of confidence and have raced on to new highs recently.  Once again, conventional wisdom was turned on its head as virtually nobody saw this coming.  What was equally remarkable was that those market pundits who chimed in with a prediction on what would happen in the event of a win by Donald J. Trump virtually were unanimous in their view that the market would surely collapse if Trump were to win.  Oops!

We had no idea who would win the election, or what the market would do in the aftermath regardless of the results. Yet, it really does not surprise us that the market has reacted well, especially in light of the policy issues that Trump has espoused, most notable of which is a reduction in tax rates and simplification of the tax code, as well as a reduction in the level of regulation that has held back businesses for so long.

It was just in our last Investment Climate where we pointed out, yet again, how big government has held back business.  If the new Trump administration can be successful in moving forward on those two major policies, then much of the “trade” issues that Mr. Trump has also railed about should take care of themselves because we should witness considerable increase in capital investment and general business activity.

If the investment climate should finally become more favorable, then that should only enhance the prospects for many of the investments themes on which we have focused  in our portfolios.  Additionally, and perhaps most importantly, such an environment would likely benefit small business the most. We have been quite concerned about the lack of new, innovative businesses coming about, and the resulting lack of initial public offerings in the stock market.  This desperately needs to change, and if it does, we could witness the type of market activity that was brought about by the sea change witnessed back in 1980, which led to the significant market moves of the 1980s and 1990s.

We are very encouraged and would argue that it’s been quite a long time since the wind has been at the back of businesses.  This isn’t altering our investment approach at all.  We just have even more confidence in its ultimate success!

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Why smaller can be better for equity investors



When it comes to investing in a managed investment strategy -- a mutual fund, for example -- many investors do not realize that total amount of assets under management (AUM) can be an important differentiating factor in the portfolio's performance.

For example, an equity investment strategy with fewer AUM, say below $2 billion, has far more investment choices than a strategy with AUM in the tens of billions of dollars.

The reason for this situation is fairly straightforward, although it is not widely discussed in popular investment literature. 

Imagine a mutual fund which owns 50 stocks in different promising businesses, allocating 2% of the total portfolio to each company in the portfolio.

If the fund has $100 million in total assets under management, the hypothetical portfolio described above would buy $2 million worth of shares in each of the 50 different stocks. 

However, if the same hypothetical fund had $10 billion in total assets under management, the same 2% per company would now amount to $200 million worth of shares in each of the 50 different stocks.

There is a big difference between buying $2 million worth of shares in a company, and buying $200 million worth of shares in the same company. 

For one thing, placing a trade for $200 million of shares in a company will move the price of that stock much more, even if the company in question is very large with a large volume of shares traded each day.  And it will usually necessitate several days of carefully-considered trades in order to move into (or out of) that complete 2% position during which time its price can fluctuate.

But an even bigger problem for the larger fund is the fact that its sheer size will make placing 2% into many companies an impossibility, without buying the company altogether, or buying such a large share of the company that the portfolio would own 20%, 30%, or even 50% of the company (depending on the total market capitalization of the company).  

A fund with $10 billion in assets under management cannot even invest 1% in the stock of a company with a market capitalization of $100 million without buying that company completely, or in a company with a market capitalization of $200 million without buying half of the entire company. And if the fund goes up to $20 billion, then the fund cannot put 1% into a $200 million company without buying the entire thing, or into a $400 million company without ending up owning half of the entire company. 

Most investors will also understand that putting less than 1% of a portfolio into a company is not really very productive: if that company turns out to be a real winner, it won't really create very much gain if the portfolio only has 1/2 of a percent allocated to that company (hardly worth the time it takes to thoroughly research that company and to monitor its performance over time).

There are literally thousands of innovative companies with market capitalizations below $1 billion which are effectively too small for many large funds. In fact, out of the roughly 4,000 publicly-traded companies in the US listed on the major exchanges, more than 2,000 of them have market capitalizations below $1 billion, and over 2,500 have market capitalizations below $2 billion (as of 12/09/2016). 

This means that over half of the companies trading on the major exchanges will be effectively "off limits" for practical investment for a mutual fund with tens of billions of dollars in assets under management, simply by virtue of the fact that those funds are too large to be able to take a position in those smaller companies. 

To make matters worse, many of the biggest opportunities for growth will be found in companies with smaller market capitalizations. Companies that have only recently gone public, for example, may begin their careers as public companies with market capitalizations in just this capitalization range. For example, the innovative Internet-of-Things company Impinj* (ticker symbol PI) came public in July of 2016, and its current market capitalization is in the neighborhood of $600 million.

A fund with $60 billion in assets simply cannot invest even 1% in this name without buying the entire company (thereby taking them private again), while even a fund with just $15 billion in assets cannot take a 1% position of Impinj in its portfolio without owning 25% of the entire company.

However, a fund with only $1 billion in assets, or even $2 billion in assets, would have no trouble taking a position of 2% in a $600 million company like Impinj.

If you think of the job of running an investment strategy as somewhat analogous to participating in a fantasy football league, the reality described above basically means that portfolio managers of larger funds have more and more potential "players in the league" off-limits to them -- and the number of potential players who become off-limits grows as the investment portfolio gets larger. At around $2 billion and upwards (in terms of AUM), investment portfolios begin to have a harder and harder time investing in small-capitalization companies.

Note, however, that while a portfolio manager with tens of billions of assets under management cannot effectively own smaller capitalization names, a portfolio manager with fewer assets under management can still invest in BOTH larger and smaller capitalization companies without any problem. 

Investment options diminish as an investment strategy gets bigger,as does the speed with which the strategy can buy or sell an investment position. For these reasons, we believe that for some investment goals, investing in funds with fewer assets under management can offer greater opportunity.



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* Disclosure: at the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Impinj (PI).



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An Historic Election


The 2016 U.S. presidential election was clearly a watershed in American politics, if for no other reason than because a person who has never held any political office has made it to the highest ranking office in the nation and, once again, America sets the stage for peaceful change.  That said, we will keep it brief and stick to the effects we think the transition will have on the economy and our portfolios.

As many who have followed our writings in the past know well, we have been highly critical of the heavy-handed role of government into the affairs of the private sector in the 21st century.  We believe anything that can stem the tide of government overreach will be a boon to the economy, and ultimately the worth of companies.

As it relates to the economy, Donald Trump's campaign focused on three primary policy objectives: trade, regulation, and taxes.  Specifically, he claimed he would "renegotiate" trade agreements like NAFTA (North American Free Trade Agreement) and TPP (Trans Pacific Partnership) and levy tariffs on goods entering the U.S. that are made in countries like Mexico by U.S. companies manufacturing there.  With respect to regulation, he suggested he would reduce, or even eliminate regulatory regimes like Dodd-Frank and Sarbannes-Oxley, which have served to inhibit business formation and expand the already burdensome size of government bureaucracy.  As for taxes, he supported "across the board" tax cuts on both individuals and businesses, most importantly advocating for a reduction in the U.S. corporate income tax rate (which currently the highest of all developed countries at 35%; he wants it cut to 15%) as well as simplification of the tax code.

We could not be more emphatic in our support for the latter two objectives of President-Elect Trump.  Anything that can be done to reduce the tax burden on businesses, both large and small, will help the economy and ultimately the employees (and future employees) of those businesses. The same holds true for the reduction of burdensome regulation on businesses.  Sensible regulation is one thing but, today, regulations have become more about promoting political "pet projects" than ensuring safety and adherence to common sense best practices.

As for trade policies, we believe that it would be a mistake to become protectionist in today's global economy.  Like it or not, globalization is here to stay and denying that will only serve to reduce the standards of living for all American's, as well as for consumers in the rest of the world who buy our goods and services.

At the end of the day a tariff is a tax on consumers, and while there is no doubt that other countries (including the United States) try to "protect" certain favored industries and workers, in this case, two wrongs don't make a right and it does no good to exacerbate trade wars.  Mr. Trump is a real estate investor by trade, and, as such, is comfortable negotiating. To the extent he can "negotiate" equitable trade deals, we wish him the best, but it should by no means be at the expense of free trade!

Fortunately, the incentives that would be created by fixing the tax code and reducing regulations may well solve many of the problems of lagging capital investment that has plagued the rust-belt areas who so emphatically supported Mr. Trump and have been understandably frustrated by the lack of new jobs.  Almost $3 trillion dollars in U.S. company cash sits overseas because it would be taxed at 35% if it was repatriated to the U.S. Unlocking that cash would go a very long way in promoting the necessary capital investment that would help propel many of the hardest hit areas in the country.

Regardless, the two points of policy we believe are very favorable, regulatory reform and tax reform, will be much easier to enact and will be well on their way to helping the economy before any poor trade policy could ever be enacted.  In fact, we believe it is unlikely that any seriously damaging trade policies would ever make it to realization.

All in all, we are very encouraged and hopeful by the prospects of the changes we have discussed.  We look forward to seeing these put into practice because if they are given the chance, all Americans  will be better off.
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Investment Climate October 2016


The stock market recovered nicely in the third quarter after the “panic” over the Brexit vote subsided and the focus turned to the slow but consistent growth in the economy that has prevailed for a number of years now.  Markets in general, as well as our Core Growth Strategy, ended the third quarter with a year-to-date return in the mid-single digits.  

While some would marvel over the market’s move upward since the 2008-9 debacle, we believe that viewing market performance with a start date of March 9, 2009 (the day the market bottomed in the wake of the crisis) is a big mistake.  While we are pleased, and frankly, not surprised that the market has recovered from the depths of its decline in 2009, we are dismayed at the significantly below- average growth in the economy, and in the price of the average stock over the course of the last 15+ years.  Although during that period we have witnessed outperformance in our Core Growth Strategy versus the market in general, we have not seen the kind of growth we would have expected considering the massive technological advancements that have benefitted the world over that same period of time.

We will begin by emphasizing that we are more confident than ever that the types of companies we focus on in our strategy are poised for significant success which we believe will be reflected in their stock prices in the years to come.  But why has it been such a slow slog forward?  

Simply put, the “investment climate” of the last 15 years has not been ideal, and particularly it has not been well-suited towards entrepreneurial activity and capital investment.  The reasons for this are plentiful, and have been discussed before, but to recap what we believe to be the primary culprits: government intrusion into the affairs of free enterprises has been, at best, meddlesome and, at worst, stultifying.  With all good intentions, and in the wake of scandals like Enron and Worldcom in the late 1990s, and the mortgage/housing/ financial crisis in 2008-9, the politicians “acted” by giving us regulatory regimes like Sarbannes-Oxley and Dodd-Frank (with its offspring, the Consumer Finance Protection Board) that has made it increasingly difficult for businesses (especially smaller ones) to navigate the already complex web of regulations.  If there is need of evidence of this problem, to us -- professional investors who seek out growing businesses for a living -- one need look no further than the dearth of initial public offerings (IPOs) of common stock in the last 15 years.

This drought has become an epidemic, in our view.  While there have been fits and starts in the IPO market over the last few years, the general trend has been abysmal for so long that it has considerably limited our ability to find new growing companies in the public markets.  This is, in our view, the single most important issue facing the investor today!

Fortunately, we believe we have such a formidable group of opportunities in our strategies for growth investing in both public and private companies that we don’t fear this situation, yet.  As previously mentioned, we have never been more confident in the positions we have taken in both public and private holdings.  However, it does concern us for the future, and particularly future generations of investors, that this drought in new business formation has run for so long.  As we have said for years, echoing our mentor Richard C. Taylor: “we get by in spite”.  When Dick spoke those words he meant to describe the errors of the ways of those who have over-intruded into the private affairs of businesses, just as we have witnessed in the last 15 years.  

While we acknowledge the challenges that such intrusions place on businesses, we are optimistic that the remarkable business men and women who run the companies we own will shine regardless of what unintended hurdles are foisted upon them.  Doug Waggoner from Echo Global Logistics, Eyal Waldman from Mellanox Technologies, Colin Reed from Ryman Hospitality Properties, Arkadiy Dobkin from EPAM Systems, Anat Cohen-Dayag from Compugen, Jules Urbach and Alissa Grainger from OTOY, just to name a few, are examples of the brilliant and committed stewards of our companies who, with their entrepreneurial spirit and innovative products and services, are impacting our world.  Fortunately, we can benefit as we standby and watch them do their work!

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